Thursday, August 29, 2013

Settlement of Trade is Crucially Different from What Most People Expect

Settlement is a crucial part of a functioning trade system. Of course that's true, most people might say, as they expect settlement for deals that they undertake in their daily life. Most deals people engage in are settled almost immediately, like when you make a cash purchase at a store. The cash is paid and the item is handed over to the customer, at which point the deal is settled. Other transactions aren't settled for some time such as credit card purchases where products and services are purchased, but the bill isn't paid until several weeks later. Only when that bill is paid in full are the purchase transactions settled. The one event that many people experience that is actually called settlement is closing the purchase of a house. When all the details are worked out and the funds are available the parties go to settlement. There the payments are made and the deed to the house handed over to the buyer with the keys. The element that is the same in all these familiar transaction settlements is that they are accomplished by exchanging the good or service for money. Handing over money for the purchase settles the transaction.

But why would someone take money for settlement? This might seem and odd question because we do it so often that we hardly even think about it. But at other times people did think about this question when being offered cash for settlement. Such as in US colonial times when the cash offered was from another colony, or in Weimar Germany when cash was plentiful, but the value of that cash was in question. This last example may be the ideal reason why someone might question taking money in settlement. The reason is that its not the money that someone wants, rather its the goods and services that the money can buy that the person wants. The only reason that money is taken in settlement is that it can be exchanged for goods and services. The goods and services have real value, while the money is merely a medium of exchange that promises to deliver those goods and services in the future. Money is, in a sense, an IOU for goods and services in the future.

To make this clearer, consider the possibility of using a different currency then the one used in your country. For example in the US we use the USD. What if we decided to use a different currency? But not just any currency, rather one that everyone around the world recognizes, is in plentiful supply, is easily divisible, is fairly durable (I've had some for nearly fifty years). That currency is Monopoly money; from the Parker Bros. toy company game of the same name. Everyone has played Monopoly at least once if not many, many times. So, wouldn't that be a great new currency? Imagine you go into work tomorrow and your boss says "we're going to start paying you with Monopoly money". You get the same pay as you did in USD, but now it is in Monopoly dollars instead. Would you take that money as pay? Probably not, because in spite of being in wide spread circulation and readily recognizable, Monopoly money has little actual value. You couldn't exchange it for goods or services, which we've already said have real value.

Being paid in your local currency is generally considered safe as all transactions happen in that currency, and all debts and taxes are paid in that currency. In a sense, the deal isn't really settled until you've spent that money on other goods and services as those have the real value. And most of the money that is transacted is then spent soon after on another transaction. Some money, but not much, is saved as cash for future use, so in that same sense most transactions are quickly settled in daily life.

Which brings me to settlement of trade. We said previously that trade is the exchange of goods and services from one country for goods and services from another country. And that what we do today for trade are multi-currency purchase and sale transactions. So, unlike transactions we experience in daily life, trade transactions are not settled by exchanging money for goods and services. Rather the money is like that IOU which is held expecting to be exchanged in the future for goods and services from the money's country of origin. The value of the money is the countries ability to produce goods and services to exchange for that money. As long as the money from trade is outstanding the goods and services haven't been produced for the foreign entity so, the trade isn't settled. With outstanding money there is still an expectation of getting goods and services from the other country. When a deal is truly settled, there are no outstanding expectations. The transaction is complete and they parties have no further interaction.

Large trade deficits are therefore, large numbers of unsettled transactions. Only when the money is exchanged for goods and services from the money source nation can the trade be said to be settled. The US has been running massive trade deficits for many years totaling around $10trillion of trade debt. That really constitutes a massive lack of trade settlement. Settlement that will have to be made one day. The only way for the US to settle this debt is to start producing the goods and services that the holders of the debt will buy with the outstanding money they hold. When will this happen? and how? Those are key questions as to what will happen in the US economy in the future.

About Me

I have a Ph.D. in physics and work in technology research and development. I've done work on muonic atoms, plastic solar cells, Hydrogen storage for fuel cell cars, and wireless lamps. I've worked on a variety of systems for space systems, defense and cyber security. Besides the technical world I have a strong interest in politics, economics, and finance and how they affect the future of the US.